Earlier this year, the Internal Revenue Service changed and clarified its views with respect to the US tax treatment of Registered Education Saving Plans (RESP), Tax-Free Savings Account (TFSA) and non-US mutual funds. If you hold these types of investments your filing requirement is dramatically changed in terms of your US reporting. The changes can be broken up into two areas RESP/TFSA and Non-US Mutual Funds; we have provided a brief summary of these changes and potential impact.
Holders of RESP and TFSA
The US has determined that these plans are classified as foreign trusts in the US and as such are required to complete two additional forms, 3520 and 3520A, to fulfill the proper filing requirements in the US. Both of these forms are quite extensive in terms of the information needed to complete them. A breakdown of the forms are:
3520 Annual Return to Report Transactions with Foreign Trusts
Required to be filed
o if the US person received a distribution from a foreign trust or
o You are a US person who is treated as the owner of any part of the assets of a foreign trust under the grantor trust rules
Return is due on the date that your income tax return is due, including extensions
Penalties if not timely filed or incomplete or incorrect is up to 35% of the value of the property
Earlier in the year the IRS determined that Canadian mutual funds should be classified as a corporation rather than a trust for US tax purposes. The classification as a corporation for US tax purposes may result in the investment being classified as a passive foreign investment company (PFIC). A PFIC is a non-US corporation that meets either an income or asset test. The income test is met if 75% or more of the foreign corporation’s income is passive in nature (interest, dividends, rents, royalties, etc.). The asset test is met if 50% or more of the assets held by the non-US corporation are used to produce passive income. If either of these tests are met then the holding is subject to the PFIC rules for US tax purposes.
For 2010 and earlier the PFIC rules require an individual to file form 8621 which may or may not be required annually. For 2011on, the Obama administration is in the process of revising form and requirements. The PFIC rules are very complicated and currently there are three methods that an individual can use to comply with the regulations:
1. Qualified Electing Fund:
Under the first method the investor of a PFIC can elect to be treated as a Qualified Electing Fund (only available if the PFIC provides the investor with the necessary information). If elected they are subject to tax on their pro rata share of net capital gain and ordinary earnings, which will be taxed as ordinary income regardless if such amounts are actually distributed.
2. Excess Earnings Distribution:
Under the second method if no QEF election is made they are taxed under the special excess distribution provisions. Here, a U.S. investor is permitted to defer tax on the PFIC’s undistributed income until the U.S. investor either disposes of the stock or the PFIC makes an excess distribution. This option is highly punitive.
3. Mark to Market:
Under the third method you can do a Mark to Market election (assuming it is a marketable stock). If the election is taken then they would recognize a gain or loss on the shares each year based on the fair market value at years end. A loss would be realized to the lessor of the current year loss and the amount that has been brought into income in the prior years.
There is no specific penalty for not filing but the advantage is that an individual can make an election to avoid the punitive tax on excess distributions on future distributions. The form is attached to the personal return (1040) and is due when the personal return is due. For a copy of the form see http://www.irs.gov/pub/irs-pdf/f8621.pdf .